Everyone in the media is making a big fuss over the Fed’s lack of full disclosure with regards to their discount window loans made during the heart of the financial crisis. The argument is simple – the government should be open and honest about its transactions that could be to the detriment of the taxpayer. While I sympathize with this rationale I also believe there is a practical reason behind their discrete dealings.
Anyone who understands monetary operations knows that the discount window has a stigma attached to it. Borrowing directly from the Fed is generally viewed as a sign of weakness. After all, if you can borrow in the overnight market then why would you ever resort to borrowing from the Fed with penalty? In what was clearly a pre-emptive blog post from the NY Fed yesterday, they cleared up some of this confusion in what is really an excellent explanation:
“While the discount window is an important tool for central banks dealing with liquidity problems that may threaten financial stability, its effectiveness depends critically on the willingness of banks to borrow from central banks. Banks are often reluctant to borrow from central banks not only because this source of liquidity tends to be expensive but also because of the “stigma” that is associated with discount window borrowing. As described in Courtois and Ennis, “stigma refers to a fear on the part of banks that a negative signal could be conveyed to regulators, other banks, or investors about a bank’s health if that bank is discovered to have borrowed from the Fed” (p. 1).
If a bank worries that borrowing from the discount window will lead other banks to doubt its fundamental solvency, it may avoid the discount window even if the discount window provides the cheapest funds available. Instead, the bank may liquidate marketable assets or try to borrow in the interbank market at onerous terms, further straining these markets and making it even more difficult for other banks to obtain funding or sell assets. Thus, central banks typically disclose only a limited amount of information about discount window activity to avoid branding healthy (but illiquid) banks as weak. The Federal Reserve, for example, has historically published the total amount of borrowing from the discount window on a weekly basis, but not information on individual loans. By allowing banks to borrow confidentially, this policy aims to make healthy institutions more willing to use the discount window during periods of market stress. It should be emphasized that confidentiality is not meant to protect the identities of individual banks per se, but rather to make the discount window more effective in dealing with market disturbances.
Central banks have long recognized the challenges that stigma creates for the effective operation of the discount window during crisis. Donald Kohn, former Vice Chairman of the Fed, has discussed the stigma problem in past speeches. “The problem of discount window stigma is real and serious. The intense caution that banks displayed in managing their liquidity beginning in early August 2007 was partly a result of their extreme reluctance to rely on standard discount mechanisms,” Kohn noted in a 2010 speech. In fact, the need to mitigate stigma influenced the design of some of the lending facilities, such as the Term Auction Facility, created by the Fed during the financial crises.
In sum, the discount window is a vital tool to maintain the uninterrupted functioning of the banking system, but its effectiveness may be limited by the stigma associated with using it. This explains why policies that aim at dealing with the stigma of discount window borrowing are so important. Admittedly, the existence of the discount window may create some moral hazard, but of course, the Federal Reserve limits moral hazard by restricting discount window access to depository institutions that are closely regulated and supervised by federal banking authorities.”
If you recall the period surrounding the financial crisis, there were rampant rumors about discount window borrowing and every time a firm was rumored to be at the discount window the company was rumored to be insolvent. One of the primary purposes of the discount window is to provide emergency funding at a time when credit markets are seized up. This means that even solvent firms could need to go to the discount window in times of crisis. When there are broad based fears the Fed becomes the only game in town. If the lender of last resort function were not there this crisis would have been monumentally more catastrophic.
The issue here is with regards to disclosure. Should healthy firms have to disclose the fact that they are receiving emergency loans? That’s a tough one to tackle, but I think the stigma surrounding the discount windows can lead one to conclude that this sort of disclosure will only exacerbate problems when it is most needed. In essence, a disclosure policy defeats the purpose of the discount window’s very existence if it is viewed as an act of desperation. The Dodd-Frank bill will impose a 2 year embargo on all discount window operations. Personally, I think that’s one of the few rules in the bill that actually makes any sense.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.